Just over a week ago, on April Fools’ Day, the Dow Jones Industrial Average rocketed by almost 400 points — and it was no joke. The rally was solid and meaningful, although that meaning might elude most highly paid Wall Street gurus.
Before I tip my hand as to the origins of the rally, I need to revisit the dark days of October 1987, and the brighter days that followed, to help make my point.
As a growth-fund manager back in the late 1980s, I found myself at the center of the cyclone that became known as Black Monday. Market pundits arrayed a formidable list of fundamental and technical explanations as to why the market collapsed that October day. Yet few, if any, were accurate. One of Wall Street’s top-rated economists even created a “Depression Indicator,” which was designed to track events in the expectation of 1930s-like depression. This effort proved futile since the economy was in fundamental good shape and the financial markets recovered.
Why were the Wall Street gurus wrong? Like today, they fail to understand that when too many fisherman get on one side of the boat, the boat will lean to the side that they’re on — and sometimes tip over.
The 1987 crash was sparked by a proliferation of portfolio insurance and an investment strategy created by a firm in San Francisco named Leland, O’Brien, and Rubenstein. The firm mesmerized institutional investors into believing they could actually insure their equity portfolios. The idea was to sell stocks and hold cash when the market declined, such that the percentage decline of the “insured” portfolio would be less than that of the market decline. The idea was so well accepted that many institutional investors “bought” this insurance policy.
The problem with the strategy was volume: The combination of too much portfolio “insurance” and a market decline created a snowball effect where losses equated with further selling, thus exacerbating the destruction of wealth. In other words, too many fisherman moved to one side of the boat and the boat tipped over.
Fortunately, the Federal Reserve stepped in, opened its checkbook to the market makers on the New York Stock Exchange, and prevented a meltdown. After that, the Treasury implemented measures that would prevent future portfolio-insurance gaffes.
And as for the stock market, it never looked back — just onwards and upwards.
The second part of my story begins in 1992, when I became involved in the design of asset-allocation portfolios for 403(b) and 401(k) retirement plans utilizing mutual funds. The process is now called lifestyle, or lifecycle, investing. Back then few firms offered a managed-portfolio strategy that was designed for retirement savings, and the idea of a portfolio that was rebalanced each quarter to maintain a targeted asset allocation made a lot of sense. Simply, the age-old axiom that markets tend to return to a long-term trend provided a natural way to manage a diversified mutual-fund portfolio. Robert Arnott, a well known investment professional, provided extensive research that supported the idea of systematic portfolio rebalancing as a viable investment strategy.
Over the years, my partner and I have implemented these traditional portfolio-management techniques with over $1 billion in client assets. The strategy has worked well for our portfolio models, yet over the last few years we have witnessed a disturbing trend: the rise in popularity of systematic rebalancing.
When a few firms implement a rebalancing strategy, the market should be able to absorb it. However there has been an enormous increase in the number of lifecycle portfolios. And the recent introduction of target-date funds — a varying mix of assets that are adjusted over time to meet the needs of people saving for retirement — is just a derivation of the old lifecycle models. Making matters worse, in most cases these funds contain a rebalancing clause: a commitment to rebalance a portfolio to a pre-set asset mix on either a quarterly or annual basis.
And now for the modern-day version of rocking the boat.
The proliferation of rebalancing actions — especially at the beginning of each quarter — has created the potential for a recurring market-moving event. The only precondition — in addition to the widespread popularity of rebalancing portfolios — is a calendar quarter in which asset classes show a divergence in performance. When this occurs, the stage is set at the beginning of the following quarter for a major rebalancing “event.”
In this year’s first quarter, market volatility reigned relative to an ongoing sub-prime credit crisis and persistent signs that the economy is in a slump. The stock market plummeted and the bond market — that is, the government bond market — rallied to unheard of levels. My partner and I watched all this, and it was our expectation that when the U.S. markets opened on April 1, a breakneck rebalancing process would begin and a sizeable rally would be triggered.
The market gains of April 1 have not been given back, and by the end of the month markets again could be near all-time highs. Foreign markets might follow along, guessing that a U.S. economic slump won’t be long-lasting. And should the Wall Street technicians bank on a new bull market, they’ll join the rebalancers on one side of the boat, and help produce yet another upward surge in stock prices.
But this scenario isn’t all good news. If disparity among asset-class performance in the second quarter is substantial, look for another “correction” in July as the rebalancers pull the levers on their models and spew out mindless buy/sell orders in the hopes of getting their portfolios back in alignment.
Until the regulators get their arms around this new source of financial-market disturbance there will be a lot of volatility for no good fundamental reason. If the boat’s gonna lean violently — one way or the other — on the first day of each new quarter, investors aren’t in for a lot of smooth sailing.